MANAGEMENT FINANCIAL INSTITUTION

MANAGEMENT OF FINANCIAL INSTITUTIONS

BCOM 430
INTRODUCTION
In a changing global financial movements
particularly in liberalization of participation of
financial markets. Financial institutions are facing
challenges with more entrance into the market
creating competition and forcing wither closures,
acquisitions, mergers or management over.
However, where others fail, others succeed and
even new entrants join with different strategies
and different products. herefore to understand
how to manage financial institutions successfully,
in a changing environment, one needs to
appreciate the concepts within money and capital
markets the institutional framework of financial
institutions, the risk managerial strategies of
financial institutions is to identify the
functionalities, categorization statements and legal
systems. In addition, the risk management takes
a major part of the management of the institution because all financial institutions hold some
assets and liabilities in form of!
a) loans or deposits and consequently are e"posed to default risk and #credit risk$. his
is the risk that the borrower may not commit to repayment of the e"pected amount
within the e"pected time.
b) hey are also e"posed to interest rate risk. his risk relates to the liability to match
maturities of liabilities with the maturities of asset.
c) hey are also e"posed to liquidity risk. his is due to unprecedented or une"pected
saver withdrawals which may limit the capability of financial institutions to commit to
such withdrawals.
1
d) they are also e"posed to underwriting risks. his emanates from lack of reliable
guarantees or collateral for the loans%assets issued out.
e) they are also e"posed to operational risks. his is due to high operational leverage
resulting from unbalanced usage of real resources e.g. technology, materials, human
resource e.t.c.
FI&'&(I') *'+,-. '&/ FI&'&(I') I&.I0I1&.
Financial markets are categorized into2
i. H- *1&-3 *'+,-
he money market for financial institutions relates to transactions in e"change that pertains
to money i.e. borrowing and lending within one year, foreign e"change markets, made up of
the spot market, daily e"changed of currencies maturing in 45 hours. (apital markets for
financial institutions relates to securities usually corporate bonds and stock.
2
ii. 6+I*'+3 *'+,-
6rimary market is for first issue or transaction in a security. 'ny subsequent transaction falls
into a secondary market. Financial institutions play an important role in both the financial
market by moving funds from the pockets of deposit less into the pockets of borrowers
consume more than their income and to link the two, interest rates is used which acts as a
driving force to allocate the e"cess funds with depositors into the pockets of borrowers in the
financial markets and thus you cannot separate a financial institution from a financial market.
Financial markets therefore have two functions!
ime preference function
It is provided in the time value of money concept where financial markets provide a forum for
financial institutions access money at present and re7evaluate values of such money in future
under competitive environment through interest rates.
+isk separation and distribution
his is through allocation of money or capital and distribution of such capital to a large
clientele subsequently who accept to absorb such risks and thus the concept of risk
diversification of distribution.
+1)-.%F0&(I1&. 1F FI&'&(I') I&.I0I1&.
8. Financial Institutions e"ecute payment of finance in the financial market! 6ayment
finance entails facilitating financial transactions between trading partners by use of
instruments such as credit card, debit cards, cheque clearing systems, '*s, electronic
money transfer systems, mobile transfer systems which enable e"ecution of payments
such as salaries, debts, bills or insurance premiums. In other words it provides liquidity of
investment and borrowing.
9. ransmutation Function%ransmission of *onitoring 6olicy! Financial Institution
purchases primary securities and issue secondary securities consequently adding value
to the supply and demand of money in the economy. 6rimary securities are those
securities that provide a claim e.g. bond certificate, share certificate, loan provide%give the
issues a claim. his claim is transformed into a secondary security when these
instruments are sold from one point to another or person to another. he process of
changing primary securities into secondary securities is known as transmutation.
3
:. 6ortfolio *anagement! It relates to an advisory function whereby financial institutions
provide advice and also manage securities on behalf of individuals and companies e.g.
Investment (ompany;s advice on issues of I.6.1.s.
4. Income a" *anagement! his function relation to mitigation of ta" preferential
between individuals and business e.g. pension schemes%funds, transfer ta" deductions
from one period to another and from high to low income brackets. his enables
individuals to bridge their ta" burdens and acts as a ta" shield.
<. +isk /iversification! =ecause of the large size of some financial institutions, they are
able to purchase large numbers of investment and break it into many small
securities%instruments, consequently spreading the risk from one security to many
others or from one individual to another.
>. /enominational Intermediation! It occurs where capital market institutions transform to
money market institutions e.g. bonds transform to unit or current market.
()'.IFI('I1& 1F 6'+I(I6'&. I& H- FI&'&(I') *'+,-
6articipants *ode of 1peration +eference
Institutional
' (ommercial =anks
(redit 0nions
.aving =anks
/epository Institutions
Finance (ompanies
*icro7Finance Institutions
/epository
Institutions
Financial institution
= Insurance (ompanies
Financial Institutions
6ension rust Funds
Investment (ompanies
+eal -state Investment rust
&on7/epository
Institutions
Financial institution
4
( *ortgage =rokers
Investment =rokers
.ecurity /ealers
'gencies Financial institution
/ Households
Individual =usinesses
?overnment /epartments
Investors or
/epositors%=orrower
s
&on7Financial
Institutions
DEPOSITORY FINANCIAL INSTITUTIONS
a) (ommercial =anks
hey are depository institutions because they accept deposits in the form of negotiable
certificates of deposits, non7negotiable certificate of deposits, savings deposits, checking
accounts deposits, pass book deposits accounts and current accounts. hese liabilities are
used to issuing loans and for other investments in money and capital market securities. he
assets include other than the loans and securities commercial papers such as promissory
notes and letter of credit.
Illustration
'ssume a commercial bank of 'frica with the following information available to the new
manager as at :8
st
/ecember 9@@A!
he =ank;s total deposits include2
ransaction accounts #savings accounts worth ,shs. 8,@@@,@@@.@@
(heque book accounts worth ,shs. 9,@@@,@@@.@@
6ass book accounts worth ,shs. 8,@@@,@@@.@@
&on transaction accounts made up of negotiable certificates of ,shs.
4,@@@,@@@.@@
1ther miscellaneous deposits worth ,shs. 8,4<@,@@@.@@
he bank has the following loans!
=orrowing from other banks! ,shs. 9,<@@,@@@.@@
=orrowing from the central bank ,shs. 8,<@@,@@@.@@
he following are the loans issued in > categories!
5
o Inter7bank loans ,shs. 5@@,@@@.@@
o Industrial%commercial loans ,shs. 8,@@@,@@@.@@
o +eal estate loans ,shs. 4,@@@,@@@.@@
o +evolving home loans ,shs. B@@,@@@.@@
o Individual consumer loans ,shs. 8,<@@,@@@.@@
Investments in securities included!
o 1wner equity ,shs. 4,@@@,@@@.@@
o Investment in government bonds ,shs. 8,@@@,@@@.@@
o Investment in company bonds ,shs. >@@,@@@.@@
here is a reserve requirement of 8@C by the (.=.,. In addition there is a letter of credit
involving international trade worth ,shs. <@@,@@@.@@
+equired2
a. 6repare the banks balance sheet as at :8
st
/ecember 9@@A
b. he commercial bank is question given the reserve requirement happens to employ and
new (hief -"ecutive just a day after the (.-.1. resuming his position a client #depositor$
appears and demands to withdraw his ,shs. 4,@@@,@@@.@@ from the bank. 's an advisor
of this (.-.1. assist him to keep the bank afloat.
&=!
8. )iquidity *anagement
9. (redit +isk *anagement
:. )iability *anagement
4. (apital%'sset *anagement
=alance .heet! (ommercial =ank of 'frica
'ssets )iabilities
+eserves /eposits
.ecurities #invested$ .ecurities #Issued$
)oans =orrowings
6hysical 'ssets 1wners equity
6
a$
*anagement of (ommercial =anks =alance .heet
(ommercial =ank of 'frica;s =alance .heet as at :8
st
/ecember 9@@A
ASSETS LIABILITIES
+eserves
#8@C of total
deposits$
8,4<@,@@@
/eposits
ransaction a%c
.ecurities
?overnment
bonds,
(ompany loans
8,@@@,@@
@
>@@,@@
@
8,>@@,@@@
.aving a%c
(hequeable a%c
6assbook
8,@@@,@@@
9,@@@,@@@
8,@@@,@@@
4,@@@,@@@
)oans!
Inter7bank
Industrial%(ommer
cial
+eal
-state#*ortgage
loans$
+evolving )oans
(onsumer )oans
)etter of (redit
6hysical 'ssets
5@@,@@
@
8,@@@,@@
@
4,@@@,@@
@

B@@,@@@
8,<@@,@
@@
<@@,@@
@

5,<@@,@@@
8,@@@,@@@
&on7ransaction
a%c
&egotiable (/
a%c
&on7&egotiable
(/
*isc. /eposits
=orrowings
From
1ther
=anks
(entral
=ank
1wner
-quity
)ess /rawing
4,@@@,@@@
9,@@@,@@@
8,4<@,@@@
9,<@@,@@@
8,<@@,@@@
4,@@@,@@@
#B,9@<,@@
@$


5,94<,@@@
89,94<,@@
@
89,94<,@@@
b$ .tep I! -ffect of /eposit Dithdrawal
/eposit 88,4<@,@@@
)ess Dithdrawal #4,@@@,@@@$
B,4<@,@@@
+eserve #8@C$ B4<,@@@
i. (all loans
7
'ssets )iabilities
+eserves B4<,@@@ /eposits B,4<@,@@@
.ecurities 8,>@@,@@@ 1thers#=E1-$ BA<,@@@
)oans 4,A@@,@@@
6hysical 'ssets 8,@@@,@@@
5,94<,@@@ 5,94<,@@@
/eposit withdrawals may lead to liquidity problems such that assets may not be liquid
enough to cover the unprecedented deposit withdrawals.
Four approaches are used to solve this!
he management may borrow additional funds from other financial institution.
=orrowing from other financial institutions e"poses banks to higher interest rates
requiring that banks make prudent choices in borrowing.
=anks to call loans that are almost due. he cost of calling loans leads to the loss of
customers.
=orrowing from the (entral =ank has the same effect as borrowing from other
financial institutions which increases the cost of sourcing money.
he bank may sell some of its securities to overcome the deposit problem.
ii. =orrowing
'sset )iabilities
+eserves B4<,@@@ /eposits B4<,@@@
.ecurities 8,>@@,@@@ 1thers BA<,@@@
)oans 5,<@@,@@@ =orrowing :,>@@,@@@
6hysical 'ssets 8,@@@,@@@
88,54<,@@@ 88,54<,@@@
b) .'FI&?. I&.I0I1&.
hese are institutions that mobilize savings with an intention plus use such savings to
advance credit. he savings become part of the security attached to the credit. Institutions
with this category usually finance mortgage or real estate development. .uch a developing
bonds, commercial buildings, residential buildings and purchase of land e.g. saving
institutions therefore source most of their fund through these methods.
6assbooks
8
(ertificates of deposits a%c
1ther sources of funds are securities both money market and capital market.
'lso borrowing from other institutions e"cept the (.=.,.
=alance .heet
'ssets )iabilities
8. *ortgage )oans 8. /eposits
7 Fi"ed +ate 6assbook a%c
7 'djusted +ate Fi"ed /eposit a%c
9. &on7*ortgage )oans 9. .ecurities
7 (ommercial )oans *oney *arket #unit trust$
7 6hysical 'ssets (apital *arket #bonds$
:. =orrowing
From Financial Institutions
.'FI&?. I&.I0I1&. =')'&(- .H--
Illustrations
'ssume Housing Finance (ompany had the following information relating to its balance
sheet for the period ending /ecember 9@@A. he firm had mortgage loans divided into fi"ed
rate and adjusted rate loans worth 8.9 million and 9.5 million respectively.
(ash and investments in securities were worth : million and 9.< million respectively.
1ther loans amounted to @.< million.
6hysical assets amounted to >.< million while central bank obligations were worth 9
million. he firm share capital is made of : million while deposits tied to loans
amounting to 8< million.
=orrowings from other financial institutions were worth 4 million.
+equired
6repare a balance sheet for the saving institution.
.olutions
'ssets )iabilities
*ortgage )oans
Fi"ed rate 8,9@@,@@@ (ash :,@@@,@@@
'djusted rate 9,5@@,@@@ Investment 9,<@@,@@@
1ther loans <@@,@@@ )oans <@@,@@@
6hysical 'ssets >,<@@,@@@ /eposits 8,<@@,@@@
(entral =ank 1bl. 9,@@@,@@@ .hare (apital :,5@@,@@@
=orrowings 4,@@@,@@@
9
.ecurities! (ash :,@@@,@@@ )ess drawings #:,:@@,@@@$
! Investments9,<@@,@@@
85,<@@,@@@ 85,<@@,@@@
c) (+-/I 0&I1&.
hey are also depository institutions owned by membership through their share capital.
.uch membership usually shares a common activity, i.e. credit unions deposits are derived
from a share capital or contributions with the objective of mobilizing savings and provide
credit without profit orientations. hus the returns from deposits not interest but rather the
dividends. Dithin the governing policy, credit unions are ta" e"empted in their net incomes.
his ta" e"emption allows credit unions to charge lower interest rates on loans. Farious
products offered by credit unions are!
=1.' G =ack 1ffice .avings a%c #for savings only$
F1.' G Front 1ffice .avings a%c #acts like a bank$
*'?. G *utual 'ssistance ?roupings G provision of labour%input%asset sharing.
he regulatory system within credit unions is handled through the central banking systems
but e"ecuted by the (o7operative 'ct.
he assets and liabilities of such institutions are such as!
'..-.
- )oans #=1.', F1.', *'?.$
- 1bligations or deposits with the (o7operative =ank
- *oney and (apital *arket investments in securities.
- 6hysical assets.
)I'=I)II-.
- .avings #=1.'$ in terms of general deposits shares, chequeable deposits,
(ertificates of deposit, negotiable or non7negotiable. =ut there are no mutual
assistance deposits.
- =orrowings from co7operative bank and other financial institutions
- 1wns equity.
10
&=! (redit 0nions just as commercial banks may face unprecedented deposits and
withdrawals through both =1.' H F1.' a%cs.
d) FI&'&(- (1*6'&I-.
're financial institutions which do not mobilize deposits and thus known as contractual non7
banking financial institutions therefore they source funds from issuing securities such as
bonds, commercial institutions and thus the only source of funds of finance companies. hey
issue credit thus the assets are made up of!
(onsumer loans
(ommercial loans.
?eneral investment loans
Investment in securities, bonds or shares.
(ash deposits in other institutions.
6hysical assets.
)iabilities
.ecurities #issue or sourcing$
=orrowings
1wner;s equity
he finance companies are divided into :!
.ales Finance (ompanies make loans to households or other businesses to
purchase mainly commercial vehicles and other durables for commercial purposes.
-"amples! (F( #(redit Finance (o7operation$ and &I( #&ational Finance (o7
operation$
=usiness Finance (ompanies provide specialized credit to purchase inventory
accounts receivable financing companies. hey give credit against inventory or
stock. herefore, the inventory acts as collateral against the credit. -"amples
range from manufacturing firms that give goods on credit. In general these
institutions are known as input supply credit providers. -"ample! (onsolidated
=ank.
(onsumers Finance (ompanies make loans to household to purchase household
items2 e.g. furniture, etc., e.g. 'frican +etail raders #'.+..$
11
In general, Finance (ompanies do not necessarily provide credit in monetary items but in
kind #good and household.
e) *I(+17FI&'&(- '&/ *I(+17(+-/I I&.I0I1&.
hese are regulated by the (entral =ank through the 'ssociation of *icro7Finance
Institutions #'*FI$ to lend to small and micro7enterprises and to mobilize savings from the
same micro and small enterprises.
herefore, micro7finance institutions operate just like commercial banks, only to small
enterprises. hey also use groups through collective collateral e.g. ,+-6 holdings, ,DF,
Faulu, -quity holdings, 6ride 'frica, Family Finance.

*icro (redit financial institutions issue credit only and source funds from donor agencies or
issuing of securities such as bonds. here is no mobilization of loans%funds. -"amples2
.*-6, &((, H-)=.
f) I&F-.*-& (1*6'&I-.
hese are financial institutions whose ownership is through shares securities such as bonds
and all borrowings such as convertible debentures. hus the liability side of investment
companies are made up of!
)iabilities 'ssets
7 share capital 7 investments in the other companies e.g.
shares
7 securities issued 7 investments in debt securities e.g bonds.
7 borrowings 7 ?overnment;s securities eg. reasury bills.
7 investment in commercial papers.
7 investment in foreign bonds.
12
Investment companies usually act as underwriters for I61s i.e. after borrowings or sourcing
money through share capital and other securities such as funds are invested in the capital
market and money market securities Dith the function of underwriting shares during the I61.
he unit trusts fall under the money market are also the instruments traded by the investment
companies e.g /iamond rust Fund.
NON-BANKING FINANCIAL INSTITUTIONS WITH THE TERM NON-DEPOSITORY
A. Insuran! C"#$an%!s
'n Insurance (ompany is a non7depository finance Institution with two major products i.e. life
assurance and property insurance products.
)ife 'ssurance
he life assurance products differ from property insurance products in that they allow lending
against premiums. e.g. #products$!
i. 1rdinary )ife 'ssurance
his is where the insured receives the payment when death occurs. i.e. whole life insured,
part of the premiums can be converted into savings to act as sources of funds for lending.
he whole life assurance thus has a saving and lending component against the savings and
the collaterals are premiums.
ii. ?roup )ife 'ssurance
his is a product which involves a large number of insured persons usually its e"ecuted
through ee;s in a given organization and it has two components.
(ontributory
It is where the employee and employee both contribute partially to the group life.
&on7(ontributory
It is where only employee contributes towards life assurance2 ?roup )ife
'ssurance has no savings components and therefore does not qualify for a loan or
credit.
iii. Industrial )ife 'ssurance
his policy is contributed by the employer in relation to injuries, accidents and death during
the working hours and at the work place. i.e. workman;s compensation. It does not have a
savings component.
13
iv. (redit )ife 'ssurance
It is a policy tied to borrowing incase the borrower dies prior to loan prepayments are
completed.
v. 'nnuities
hey are insurance products in relation to liquidation of companies or bankruptcy of
companies or any eventuality that may lead to company;s closure.
vi. 'ccidents and Health )ife 'ssurance 6olicies
his is insurance against mobility or ill health e.g. '.'.+. It has no saving components
6roperty Insurance
6roperty insurance has another component %variance of liability insurance. It covers loss
through firs, theft burglary. However, liability insurance is insurance against obligation such
as negligence or fidelity. Fidelity has a variance of surety which relates to agreements and
insurance against dishonesty.
he assets of insurance companies are usually made of two components!
.ecurities G bonds, shares, 7bills
)oans G 6olicy loans, loans against premiums paid by whole life 'ssurance clients
upto the e"tent of their premium contributions.
*ortgage )oans G -"tended two savings institutions through borrowing from other
financial institutions e.g. Housing Finance borrowing from another company.
he )iabilities!
6remiums G or policy claims
6olicy dividends%bonuses arising from savings components in live assurance
products.
+eserve deposits with re7insurance G +eserves 4 insurance are deposits kept by
insurance in re7insurance but they represent future liability commitments, i.e. they
are e"pected to pay out contracts 4 policy holders who happen to withdraw before
maturity of their policies.
I&&us'ra'%"ns
'lico had the following information relating to a company;s operations,
?overnment bonds 8,<@@,@@@
6reference stock 8@@,@@@
14
(ommon stock <@,@@@
.%term investment
policy loans 84@,@@@
mortgage loans 45@,@@@
certificate of deposits 9@@,@@@
promissory notes 94@,@@@
)ife 'ssurance premium due 8,4<@,@@@
6hysical assets 4<@,@@@
1ther assets 9:@,@@@
bills 85<,@@@
+eserves :@@,@@@
/ividends on savings :9@,@@@
(ommission and ta"es payable 4>@,@@@
1ther liabilities #borrowings$ 88@,@@@
&ote. 'lico is a member of the reserve system of re7insurance and is required to maintain a
9@Creserve at all time in relation to premiums. .uppose after receiving this information, the
sales agent reports to you that one policy holder has applied to withdraw immediately a claim
worth 4@@,@@@.
+equired
a) /etermine if 'lico with its current =%.heet has not violated legislative structure of +e7
insurance,
b) Dhat options would you as a manager undertake after the withdrawal of the clientI
'lico Insurance
=alance sheet
'ssets liabilities and equity
8. .ecurities policy premiums 8,4<@,@@@
bonds 8,<@@,@@@ /ividends on savings payables :9@,@@@
6ref. shares 8@@,@@@ (omm. H ta"es 6ayables 4>@,@@@
(ommon stock <@,@@@ =orrowings from 1ther FI
88@,@@@
15
bills 85<,@@@ reserves and claims
:@@,@@@
9. )oans
6olicy loan 84@,@@@ -quity J A:<,@@@
*ortgage loans 45@,@@@
:. .hort term investment
(ertificate of deposits 9@@,@@@
6romissory notes 94@,@@@
4. 6hysical assets 4<@,@@@
1ther assets 9:@,@@@
:,<B<,@@@ :,<B<,@@@
&ote
+eserve system is 9@C of 8,4<@,@@@K9A@,@@@
:@@,@@@L9A@,@@@
b$ In circumstance where the client withdraws, the balance sheet is re7organized as follows.
are
=orrowings from other financial inst. 4@@,@@@%
.ource for more funds from re7insurance
.ell some securities from interest sensitive securities, I,e those maturing in a short
period
+ecall some of the loans
(all some short term deposits
B. P!ns%"n 'rus' Fun(
hey are trust schemes created and maintained by employees, unions and individuals.
heir assets are made up of 9 parts, investment in securities and physical assets. Dhereas
liabilities are composed of contribution by employees, employer, income and capital growth
#if it;s a loss$
C. S!ur%') D!a&!rs* Br"+!rs
16
hey operate in primary and secondary stock market e.g Investment brokers who undertake
writing of I61 and thus trade in stock market in their own account. =rokers trade in security
on behalf of clients. 'ssets include2 sale of securities, income from securities and any other
physical assets. )iabilities are2 guarantees insecurities which are issued as I61s, claims
payables etc.
N"'!
For all financial institutions and at all times, one must maintain a positive net liquidity position
#&)6$.
&)6 is the difference between total supply of liquidity and the total demand made upon the
bank. It can be computed as follows
NLP K ,deposits - sales of non /eposit - loans H repayment - .ale of bank;s asset -
borrowing from money market$ . , deposit withdrawals - loans request accepted -
repayment of )oans - 1ther operating e"pense - dividend payments/
Mana0!#!n' "1 Ass!'s an( L%a2%&%'%!s
.trategies employed include managing2 asset, liabilities, capital%equity management and
liquidity management.
O23!'%4!s "1 #ana0!#!n' "1 1un(s
Folume ratio mi". -ntails evaluation of the cost% returns% price of both asset and
liabilities
*aintaining diversification and duration analysis. /uration analysis is the process of
matching maturities of assets and that of liabilities
o ensure ma"imizations of returns and minimizations of costs
Ass!' #ana0!#!n'
he basis of asset management is aimed at ma"imization of profits because profits are
derived from loans issued beside securities. herefore financial institutions follow the
17
prescribed strategies in asset management in order to ma"imize returns from loans and
related securities.
.trategies for asset management include2
i. .eeking for high interest loans with low defaults risk
ii. /iversification in different asset portfolio for instance spreading investments in
securities
iii. =anks tends to hold liquid securities % assets even if such assets earn lower returns
.trategies for liability management include2
i. .elling negotiable certificates of deposits #(/$
ii. .elling callable securities e.g callable bonds
iii. -ntering into interbank lending systems that allows overnight lending
iv. *aintaining a positive reserve requirement above the (entral bank;s minimum
reserve amounts
Ca$%'a& #ana0!#!n'
his requires that financial institution maintains a steady growth in generation of its capital to
asset ratio. his ensures a retention level and steady dividends payouts.
6urpose of equity
i. -quity is used to cushion against losses in operations
ii. -quity is used in chattering financial institutions before inflows are realized.
iii. 0sed to as basis in access to financial markets in terms of credits
iv. 0sed in growth and development programmes such as branch network
v. 0sed in regulations of financial institution. hat is, a certain level of equity must e"ist
overtime in relation to assets.
vi. 0sed in mergers or other related negotiation
For a steady growth in equity, a financial institution must evaluate internal capital growth rate
#I.(.?.+$. this is a measure of how fast a financial institution manages its assets growth to
overcome a drop decline in equity asset ratio.
I.(.?.+ K return on -quity M +etention ratio #+.+$
+.1.-K &et profit% 1wners -quity
+.+K +etained -arnings % 1wners -quity
18
R%s+ #ana0!#!n' %n F%nan%a& Ins'%'u'%"ns
R%s+
+isk refers to uncertainties regarding returns e"pected from various investment. It arises
when significant variability is e"perienced when a particular investment is held. here are
usually various sources of risks. *ainly2 business risk, financial risk. )iquidity risk, foreign
e"change risk and liquidity risk.
In financial institution, the major risk arises from advancing loans to e"isting and prospective
customers. 6roper credit evaluation must therefore be carried out before giving loans and
advances so as to reduce credit or defaults risk.
' number of sources quality information available to banks includes2
a) 'udited financial statements of the e"isting and prospective customers
b) (redit rating agencies. his are entities which specializes in collection of credit
information about various companies.
c) 6ast e"perience
d) rade references
e) =ank references
f) 'nalysis of the prevailing economic conditions

TECHNIQUES OF MANAGING CREDIT/ DEFAULT RISKS
Management of c!edit !i"# of a c!itica$ in ban#" and financia$ in"tit%tion& financia$ in"tit%tion"
manage!" m%"t fo$$o' adve!"e "e$ection and mo!a$ (a)a!d conce*t" to (ave a f!ame'o!# fo!
%nde!"tanding c!edit !i"# minimi)ation. Adve!"e "e$ection i" *!ob$em in $oan ma!#et" beca%"e bad
c!edit !i"#" + bo!!o'e!" mo"t $i#e$, to defa%$t) a!e t(e one" '(o $ine %* fo! $oan".
-(e fo$$o'ing tec(ni.%e" ma, be %"ed b, ban#" and financia$ in"tit%tion" to !ed%ce defa%$t" of c!edit
!i"#/
a$ .creening and monitoring
In relation to screening, adverse selection in loan markets requires that financial institution
and banks eliminate credit risk by screening financial loan applicants. o accomplish effective
screening, financial institution must collect adequate relevant and reliable credit information
from the prospective borrowers. For business entities, audited financial statements may be
required on the basis of which various measures of financial performance may be determined.
b$ )ong term customers relationship
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Financial institution managers may evaluate past activities in the accounts of e"isting
customers. he balances of both current and saving accounts may give loan officers some
information about the liquidity of the potential borrowers.
c$ )oan commitment
his is a technique used for institutionalization for loan term relationship. ' loans commitment
is a banks commitment for a specialized period of time to provide a firm with loan up to a
given rate of interest borrower can access any amounts at a specialized interest rate.
6rovisions in the loan commitment agreement require that the borrower continuously supply
the bank with information about financial performance, position and future plans.
d$ (ollateral
In most cases where defaults risk is quite apparent from the information of debt information,
banks and financial institutions may insist on taking collateral called security to compensate
the institution in the event of default.
(ollateral requirement depends on the on the amount requested by the borrower. (ollateral
may be free or floating charge and a fi"ed charge.
Factoring may be done with or without recourse or without notifications. Factoring with
recourse implies that the borrower will have a responsibility if the bank fails to collect the
accounts receivable. Factoring without recourse implies that the borrower has no
responsibility even if the bank fails to collect the accounts receivables.
Factoring with notifications implies that the factor # can be a bank or financial institution $
notifies the firm that all the amounts in relation to accounts receivable have been collected. In
most cases factoring is from notification basis.
e$ (ompensating balances
his is a form of security required by the bank or a financial institution when it makes
commercial loans. he firm or entity that is requesting for a loan is required to maintain a
minimum amount of funds in checking account with the bank.
f$ (redit rationing
his is where lenders may refuse to make loans to the borrowers even when they are willing
to make principle repayments and interest payments as required. ' bank or a financial
institution may either refuse to approve certain loan requested or just pay a proportion of the
amount requested. 6rospective borrowers may be requested to give information about their
prospective investments and detailed business plans. If the investment is considered riskier by
the bank, credit request may not be approved.
g$ (redit insurance
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=anks and financial institution may also take credit insurance. In this arrangement, credit or
default risk is transferred to an insurance company.
MANAGEMENT OF INTEREST RATE RISK
/eposit rate
*anagers of banks and financial institution must be concerned about the institutions e"posure to
interest rate changes. 'ssessment of interest rate changes may enable the bank to determine the
effect which such changes may have on the banks financial performance.
here are usually two categories if interest rates2
)ending %borrowing rate which the bank charges on loans and advances it gives its customers. From
the banks perspective, lending rates constitutes income while from the customer;s perspective it
constitutes costs.
0e*o"it" !ate" a!e t(e inte!e"t !ate" '(ic( ban#" *a, on c%"tome!1" de*o"it". -(e diffe!ence bet'een
t(e t'o con"tit%te" t(e *!ofit ma!gin.
*anagers of banks financial institution should identify the assets and liabilities which are sensitive to
changes in the level of interest rates. 'ssessment of interest rate risk therefore requires managers to
identify, rate sensitive assets #+.'$ and rate sensitive liabilities #+.)$
Cr!(%' R%s+ Ana&)s%s
(redit risk is a danger or the e"posure of a financial institution to an inability for borrowers to pay
their loans % obligations as e"pected. If borrowers delay payment financial institution cannot match
their e"pected liabilities to the e"pected assets. In circumstances where loans are completely
unpaid, this leads to bad debts and bad debts cannot be part of risks management rather bad debts
are part of uncertainty management.
(redit risk analysis provides an insight%guidance on how loans can be merged with deposits. In
addition, in credit risk management, the financial institution can decide on the types of assets to
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invest in and the types of liabilities to accept. he ratio used should in credit risk management are
ratios for valuation of the abilities to commit to loan payment these are
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